1. Introduction

Art. 7(1) of the tax treaties permit the source state to tax income of a foreign enterprise, if the foreign enterprise has a permanent establishment in the source state. In that case, the foreign enterprise’s income – to the extent attributable to the permanent establishment – is taxable in the Source State.

As per Art. 7(2) of the most contemporary tax treaties, the income attributable to the permanent establishment must be determined in a manner as if it was an enterprise distinct and separate from the taxpayer company. Generally, this requirement may be referred to as the ‘independent enterprise hypothesis’.

The 'independent enterprise hypothesis' warrants a two-step approach: (i) factual and functional analysis of the activities carried on through the permanent establishment, and (ii) determination of commensurate (arm's length) profit margin that the permanent establishment might be expected to earn for the functions performed, assets employed and risks assumed.

 

In other words, the independent enterprise hypothesis warrants that the profit attributable to the permanent establishment must reflect the permanent establishment’s real economic functions rather than artificial arrangements between the head office and the permanent establishment. But, does it mean that the source state’s transfer pricing rules apply in respect of the ‘dealings’ between a permanent establishment and the head office? We may examine this issue with help of two decisions of the Indian Income Tax Appellate Tribunal (ITAT). In one case, the ITAT answered the said question in the affirmative, in the other case, it answered the question in the negative....